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Investment Overview for American Eagle Outfitters (NYSE:AEO)

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American Eagle Revenue per Square Foot: American Eagle revenue per square foot increased to $463 in 2011 to $521 in 2012 largely driven by the company's specific item promotional strategy that began in the second half of 2011. However, the figure declined substantially to $467 in 2013 on account of a few missed fashion call, an overall weakness in the U.S. apparel industry and fickle consumer behavior. In 2014, American Eagle's troubles continued as buyers eluded to brand for relatively fashion-forward brands such as Zara and Forever 21. Meanwhile, the retailer persistently focused on basic logo inventory, that failed to intrigue customers. As a result, its revenue per square feet declined to $448 in 2014.
However, we expect the revenue per square foot to gradually improve and reach $520 by the end of the Trefis forecast period, as American Eagle has shown some progress on merchandise and is gradually heading towards a better fashion portfolio. However, competition among teen apparel retailers is exceedingly fierce, and a single merchandise goof-up can cost the company its market share. Moreover, with prevailing weakness in the U.S. economy, buyers are searching for a balance between fashion and affordability, and American Eagle isn't the ideal solution for them given its existing portfolio. If the retailer's revenue per square foot remains slow and the figure reaches just $465 by the end of Trefis forecast period, there can be about 10% downside to our price estimate. However, consider a scenario where American Eagle maintains its merchandise well with proper inventory control and eliminates under-performing stores from its fleet. If this lifts the revenue per square foot to $540 by the end of Trefis forecast period, there can be about 5% upside to our price estimate.

American Eagle Stores EBITDA Margin: Though American Eagle Stores' EBITDA Margins declined drastically in 2011 due to an increase in cotton prices owing to floods in major cotton producing areas, it rebounded to the 2010 level of 26.1% in 2012 with an improvement in cotton prices and the company's firm inventory control. However, the year 2013 was market by heavy promotional activities throughout the U.S. apparel industry and American Eagle was no exception. Heavy discounting dragged the retailer's margins down to 19.5%.
Surprisingly, EBITDA margins improved to 21.1% in 2014 as the company was able to improve its gross margins with fewer promotional activities.Going forward, we expect margins to recover gradually as American Eagle dials down its promotional activities and ushers higher number of full price sales. Moreover, with the consolidation of under-performing stores, the company would be able to reduce its operating expenses at a fast pace. However, if the apparel market continues to be exceptionally promotional and margins remain somewhat stable at the current levels, there can be about 10% downside to our price estimate. Conversely, if market conditions improve and the company operates with more full price sales on account of its fashion offerings, pushing margins to 25%, there can be about 10% upside to our price estimate for American Eagle Outfitters.

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American Eagle Outfitters is a leading specialty apparel retailer that operates under the American Eagle Outfitters (AEO) and Aerie brands. The retailer designs, markets and sells its own brand of high quality, on-trend clothing, accessories and personal care products at affordable prices while targeting 15-25 year old customers. Through its Aerie brand, the company offers a collection of intimates and personal care products for girls. Aerie emphasizes comfort rather than glamor when its comes to women's lingerie.

Most of American Eagle's retail presence is confined to the U.S. and Canada. It operates a few retail stores in Mexico and 99 franchise stores in 16 countries. In addition to this, it operates web-based stores for its different brands, through which it ships its merchandise to 81 countries across the world.

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The American Eagle stores provide most value to the company, followed by the Internet & Catalog Business.

Revenue per square foot & number of American Eagle stores higher than Aerie

As compared to its relatively young Aerie brand which has just 112 stores, American Eagle stores have a much broader geographical presence, with close to 950 stores across the U.S. and Canada. Also, revenue per square foot of American Eagle stores at $448 is much higher than that of Aerie stores ($287). This can be attributed to the fact that American Eagle stores have a wider product variety, and Aerie isn't an upscale lingerie brand like its counterpart Victoria's Secret is.

Although Internet & catalog revenues account for just 17% of the company's overall revenues, they have grown at a rapid pace over the past few years. During 2009-2014, AEO direct revenues have grown by more than 11% annually driven by growing popularity of online apparel shopping. Interestingly, while the overall company struggled in 2014, its direct channel sustained its growth momentum. Going forward, this is likely to continue.

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Weak brand loyalty for American Eagle

The U.S. teen apparel market is currently highly promotional, where each retailer is trying to outsmart the other one with a broader and deeper set of products. As a result, U.S. buyers have shown low brand loyalty as they have been readily shifting to the brands that provide relevant fashion at affordable prices. This trend has helped the growth of fast-fashion companies such as Gap Inc, Urban Outfitters, Zara, Forever 21 and H&M. On the other hand, companies such as American Eagle Outfitters, Abercrombie & Fitch, and Aeropostale have been at the receiving end of this trend.

Greater focus on fashion offerings

While American Eagle’s core products have struggled, its limited fashion range has found good acceptance among customers. As a result, the company is looking to strengthen this product category with more innovation in distinct finishes, fabrics and washes. The company is looking to gradually progressing its product portfolio from basic to fashion and has already seen some success. American Eagle is planning to simplify its designing system to respond to changing customer tastes quickly and effectively. It is removing layers within its designing teams, reorganizing the structure to implement direct accountability and enhancing its speed sourcing capabilities. One such development on this front is the retailer’s fast-track fashion capsules, whose designing to in-store receiving process takes just 60 days. By effectively leveraging these factors, the company will be able to increase the proportion of fashion products in its portfolio.

Growth of young brand Aerie

American Eagle Outfitters sees huge potential in its relatively new brand, Aerie. The company is looking to capitalize on the lack of competition in the young women's intimates specialty format. About 15% of the total female population in the U.S. are between ages 15 and 24. The overall lingerie market in the U.S. stands well over $12 billion, and is currently dominated by only a few established brands. The encouraging trend is that U.S. buyers have continued to spend on intimate products even during the sluggish economic environment.In 2014, Victoria’s Secret registered robust growth for its intimate products, even though the apparel industry remained weak overall. Even Aerie’s performed slightly better than American Eagle’s namesake brand during the year. With the right push, we believe that Aerie can follow in the footsteps of Victoria’s Secret. The brand can fend off the fierce competition in the intimates market as its products are affordable and more about usability than glamor.

International Expansion.

The apparel market in the U.S. is highly saturated and competitive with a large number of established brands. Moreover, the sluggish economic growth has been a big worry for the entire industry. Last year in particular, apparel retailers have struggled to achieve positive growth as cautious consumer spending and change in spending patterns have weighed on sales. Given the situation in the U.S., exploring opportunities in international markets is warranted. It will not only open new revenue channels for the company, but will also help diversify the business risk geographically. With slightly better macroeconomic conditions and lesser competition, international markets might provide American Eagle with the opportunity to operate more full priced sales.

Early in 2012, the company assumed control over its six franchise stores in China and appointed Kitty Yung as the president of its Asia-Pacific operations. Same year, American Eagle also announced the opening of its first store in Mexico. Additionally, the retailer entered the Philippines in 2013 and announced its plans to enter Thailand in the same year. Also, American Eagle opened its first retail store in the U.K. towards the end of 2014.

Development on omni-channel platform

With e-commerce not turning into a big business for many retailers despite continued robust growth, the need for omni-channel retailing has emerged. The entire apparel industry is gradually shifting towards this concept, which appears to be the future of retailing. Over the past couple of years, American Eagle has taken several steps towards the development of its omni-channel platform and all of them have shown good promise so far. Its "buy online and ship from the store" pilot program has helped it attract those customers, who could have shied away from the retailer if the inventory pool wasn’t integrated across all the channels. The initial roll out was slow, but the company soon went aggressive on its deployment.

The retailer reported that its BOSS program has exceeded all expectations, and this might help it operate with fewer markdowns and better inventory utilization in the future. Also, American Eagle has improved its delivery time significantly and it now delivers products in two days or less to more than 90% of its customers. It opened a new "state of the art" fulfillment center in Pennsylvania in July 2104, that has played an important role in improving capacity and delivery efficiency. In addition, American Eagle has several other projects planned that are intended to optimize shopping experience across online and mobile channel. It is in the process of adding new features to its website including 360 degree product view and more on-body product display. The company is relaunching an updated version of its mobile app, that will now run faster and have a better interface.

All these efforts, along with the anticipated growth in online apparel sales, are likely to help American Eagle improve its store productivity.

Store consolidation

American Eagle operates a vast network of over 900 mainline stores in the U.S. While such presence enables the company to encompass a large customer demographic, it also increases the chances of self-cannibalization. There also exists a possibility that the retailer operates certain stores in regions where foot fall is significantly lower than what the stores can handle. Under such situations, stores do not operate at their full capacity, which results in low RPSF and higher SG&A expenses. Since American Eagle is already struggling to attract customers due to low brand loyalty, it is planning to close under-performing stores to offset the impact of low store traffic.

In its Q1 2014 earnings call, American Eagle’s management stated that it has identified 150 stores to close in the next three years out of its 300 stores whose lease will expire by 2017. By shutting stores that do not run on their full capacity, American Eagle will be able to reduce its square footage at a faster rate than its revenue decline. This will result in an improvement in its revenue per square feet. Also, its SG&A expenses will come down at a faster rate than its revenue decline, positively affecting its operating margins. However, the company cannot close stores beyond a certain limit, as it needs to have a store network capable enough to support its omni-channel needs. Hence, we believe that American Eagle will continue to open stores simultaneously at lucrative locations, and might not close any more stores after it is done with these 150 outlets.

Factory channel is promising

American Eagle’s factory channel, which was launched not too long ago, has been generating better sales than the company’s mainline stores. During 2013, factory stores delivered positive comparable store sales, despite the tough retail environment, and the retailer saw improvement in 2014 as well. Although currently this channel is not big enough to have a material impact on American Eagle’s results, the U.S. market does provide huge room for its growth. The retailer opened 39 factory stores in 2013, and another 26 in 2014.

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We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.

We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.

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